Tuesday, November 30, 2010

“The Korean Peninsula, War and the DJIA – Does History Provide a Clue?”

November 30, 2010

There are growing concerns that rising tensions in the Korean Peninsula may be felt in equity markets. A week ago, North Korea began shelling the island of Yeonpyeongdo, which lies in disputed waters south of the Northern Limit Line, but north of the Military Demarcation. Unlike the torpedoing of the Cheonan last March, this was an overt action. The North Koreans did not deny their responsibility for the deaths of two soldiers and two civilians and the homes they destroyed on the island. They were emboldened by the lack of response to the attack earlier in the spring. Whether retaliation (other than joint military exercises in the Yellow Sea with the U.S., but without live ammo and a refusal to attend the six-party talks) from the South will be forthcoming remains in doubt. Nevertheless, Zbigniew Brzezinski (President Carter’s national Security Advisor), in last Tuesday’s Financial Times, wrote: “It is an outrageous action that could qualify even as an act of war.”

In the fifty-seven years since the armistice was signed on July 27, 1953, there have been numerous skirmishes, but the recent escalation is worrying. North Korea is a nuclear power. Not unnaturally, China has been flexing its muscles in the region. The United States is occupied in the Middle East and Afghanistan; Iran remains a problem. A leadership transition is underway in the North. Kim Jong-iI recently promoted his young son, Kim Jong-un, to Four Star General, an indication that he is being groomed to become the next “Supreme Leader”, though any actual change may be years away. And there must be grizzled, senior army officers who are a little miffed to have to report to this 27 year-old. While North Korea appears politically erratic, Stratfor, in a note out last Thursday, stated: “North Korea’s notoriously irrational behavior is actually deliberate, carefully cultivated and purposeful.” Stratfor, in the same piece, points out that the North has struck recently with impunity, which may have given them increased confidence. They also raise the question, “… is this ability to calculate weakening as a result of the internal strains of the power transition, or other unseen factors?”

Seoul lies in the northwest of South Korea, about fifty kilometers from the Demarcation Line, in easy target distance for conventional artillery fire. Moreover, the immediate environs of Seoul comprise, according to Stratfor, about 46% of the population and 24% of their annual GDP, making the country vulnerable should Pyongyang decide to get more aggressive. On the other hand, despite China’s refusal to condemn North Korea’s actions, she can have no interest in seeing this incident ballooning into a full-fledged conflagration. But China is interested in increasing her military strength and presence in East Asia. Among her interests, not surprisingly, must lie in supplanting the United States as the dominant naval force in her part of the world.

The situation on the Korean peninsula highlights the problem of rogue nations – those with little or no skin in the international geo-political game of diplomacy – gaining nuclear weapons. It also underlines that far more important than the START Treaty is the imperative need to build missile defense systems. The Wall Street Journal’s front page article this morning on Russia’s moving short-range tactical nuclear warheads to facilities close by our NATO allies serves to emphasize the need for missile defense. Regardless, one nuclear weapon, in the hands of North Korea or Iran, is more dangerous than six hundred or a thousand such weapons in Russia.

But to return to the title of this piece, there is little in the history of the last hundred years that provides a pattern for the future, should hostilities in the Korean peninsula become war. The market generally sells off in the initial months (or first couple of weeks, in the case of the First Gulf War), and generally rallies through the end of the war. In World War I, the NYSE shut down for the first four and a half months – with the DJIA opening about 30% lower when it finally opened in December 1914. However, by the Armistice the Averages were up 21.2% at 88.06, providing a compounded return of 4.5%.

On Saturday, December 6, 1941 the DJIA closed at 116.60. After Pearl Harbor the Averages declined, bottoming on April 28, 1942 at 92.92 six weeks before the Battle of Midway on June 4. As one of the most decisive battles during World War II, investors came to believe that the Allies would ultimately prevail. By VJ Day (August 14, 1945) the market was 41.3% higher than it had been on December 7, 1941 .

.When the war (police action) in Korea began on June 25, 1950, the DJIA were at 224.35. Three weeks later, on July 13, the Index was at 197.46, down 12%. However, three years later when the Armistice was signed on July 27, 1953, the Averages were 19.7% higher than they had been when the war began, providing a compounded return of 6.2%.

During the eleven and a half years of Vietnam stocks gained 9.6% - from November 2, 1963 when South Vietnamese President Ngo Dinh Diem was assassinated, with at least tacit approval of the Americans, until April 30, 1975 when South Vietnam President surrendered unconditionally to North Vietnamese Colonel Bui Tin and helicopters lifted the few remaining Americans from the roof of the embassy, compounding at a dismal 0.8%. On the other hand, using the Gulf of Tonkin Resolution passed by the Congress on August 7, 1964 as the starting point for the Vietnam War, the DJIA flat-lined for ten years, nine months – 829.15 to 821.34.

The First Gulf War began on August 2, 1990 with the DJIA at 2864.60 and ended February 28, 1991 with the DJIA 2882.18. The current Iraq/Afghanistan Wars stem from 9/11. On Monday, September 10, 2001 the Averages closed at 9605.51. They reopened a week later and closed that day, September 17, at 8920.70, down 7.13%. They closed the year at 10,021.50, but we were in the middle of a bear market that had nothing to do with the Islamic terrorist attack, so the market continued to sell off until making its low in October 2002.

Economic conditions, along with the secular/cyclical waxing and waning of investor enthusiasm, appear to play more important roles in the stock market, at least over time, than do military conflagrations. One might conclude that war helped bring us out of the Depression during World War II and that war aggravated the economy during Vietnam, as President Johnson pursued a policy of “guns and butter”. But, as is normal in our business, there are no easy answers.

Trading on “inside information” has long constituted a crime. Regulation FD (Fair Disclosure), adopted by the SEC in August 2000, was an attempt to refine exactly what constituted inside information – material non-public information disclosed to one investor must be publically disseminated. Regardless, what constitutes “material information” remains a matter of interpretation. The real consequence of the rule has been to broaden the grey area between what’s legal and what is not. With a regularity that seems contrived, government agents have once again determined that this crime demands an aggressive full court press.

Both the U.S. Attorney’s Office for the Southern District of New York (appointed by the President) and the New York Attorney General’s Office (elected by citizens of New York) have been stepping stones for successful careers. Rudy Giuliani used the office of U.S Attorney to be elected Mayor of New York in 1994. Eliot Spitzer used the office of New York Attorney General to elevate himself to the governorship of New York in January 2007, a position he held until his personal predilection for peccadilloes caused him to resign a little more than a year later.

In February 1987, Rudy Giuliani, then U.S. Attorney, charged Richard Wigton of Kidder Peabody with insider trading, had him handcuffed and marched out of his office. Three months later the charges were dropped. Two years later, in an attempt to prosecute Mr. Milken, Giuliani stormed into the offices of the $3 billion-in-assets firm Princeton/Newport. The charges were later overturned on appeal on the grounds that what the principals had done did not constitute a crime. Nevertheless, the damage had been done. Mr. Wigton’s career had been destroyed, Princeton/Newport and Drexel Burnham closed. In 2003 Eliot Spitzer sued Dick Grasso, President of the NYSE, accusing him of keeping some of the board in the dark as to $140 million deferred compensation package. On July 1, 2008, the New York State Court of Appeals dismissed all claims against Mr. Grasso. Mr. Spitzer infamously charged Maurice “Hank” Greenberg, chairman and CEO of AIG for fraud, forcing the board of the company he had founded to fire him in March 2005. Following a subsequent investigation all criminal charges were dropped against Mr. Greenberg.

Both men, in their quest to trap a “name” (one recognizable to millions of voters) damaged the names and reputations of a number of innocent people and cost hundreds of others, if not thousands, to lose millions of dollars – including tax payers who funded these quixotic attempts at justice.

Preet Bharara, the U.S. Attorney for the Southern District of New York, is leading the current charge against what he has termed “the largest hedge fund insider trading case in history.” He, too, one can feel certain, has his eye on a bigger prize. In the meantime his actions have already had consequences. According to Friday’s Financial Times: “Investors have sought to withdraw about $3 billion from FrontPoint Partners, a hedge fund with $7 billion in assets.” Other hedge funds named will likely face similar disruptions. Funds will be closed. Jobs will be lost and investors will likely lose hundreds of millions of dollars. Fiduciaries, generally responsible for the bulk of assets in hedge funds, have little choice but to pull money at the first hint of trouble. Whether it is the U.S Attorney, the SEC or the Attorney General, the consequences of their charges are that a lot of innocent people – employees and investors – get hurt. It behooves them to proceed with caution However; in their view, the prospect of a political victory takes precedence over jurisprudence.

Information is at the heart of what makes Wall Street research function and though rules such as FD are designed to level the playing field, the truth is the field will always be rutted. In large part that is because people in this business have varying talents and differing work ethics. Analysts are not now and never will be equal. Some have good gut instincts, a quality that cannot be taught. Others are able to analyze numbers more proficiently than their competitors. Some are willing to walk that extra mile, stay later at their desks or spend more time on the road. And lastly, some are better at making judgments. A good analyst, whose job is to determine the value of a business, ferrets out information in differentiated ways – going through all the publically available numbers, doing channel checks, talking to customers or suppliers and then imposing his or her own interpretation of the data.

In his story of the supernatural, The Gap in the Curtain, John Buchan writes (in a different context), “Success, he had argued, depended upon looking a little farther into the future than other people.” Similarly, successful analysts attempt to predict the future for the companies followed – sales, cash flows and earnings – more accurately than their peers. In an op-ed in last Wednesday’s Wall Street Journal, Holman Jenkins wrote: “In the SEC’s ideal world any information originating inside a company will be reflected in stock prices only after the company has publically announced it to the world’s investors simultaneously.” But the real world is not so sanitized. Mr. Jenkins goes on: “A company cannot do business without revealing itself to its customers, its suppliers, the guy who drives by and sees a parking lot more full (or empty) than the day before.” That is what a good analyst does.

The passing on of true inside information can never be the fault of just one party. An analyst or portfolio manager, should he or her be guilty of trading on inside information must have received that information deliberately from someone of consequence within the company, almost always for compensation.

This is not meant to suggest that illegal activity and corruption do not exist in corporations or on Wall Street. They certainly do, but it is not rampant. The proprietary desks of sell-side firms’ and high frequency trading platforms deal within a far murkier environment than do conventional, customer-driven sell-side research analysts. Most research is perfectly legitimate – even those that employ outside consultants – with analysts and investors using their brains and their instincts to get an edge on the competition. However, neither do I agree with the concept that trading on inside information is a “victim-less” crime. There are always victims. Someone who buys or sells on privileged information, by definition, engages a counter-party. That person, for either buying too high or selling too low, is a victim, in my opinion.

The biggest problem with Wall Street continues to be the persistence of banks too big to fail – a situation not only left in place with Dodd-Frank but, in reality, enhanced. In private companies and partnerships, returns to labor and to capital are one and the same. The capital deployed is that of the partners, or owner-operators. In public companies there is a distinct difference; labor employs capital provided by outsiders. On Wall Street, within these large publically owned banks, labor takes the lion’s share of profits and does not, to any real extent, participate in the losses. Capital receives de minimis returns, yet assumes the bulk of the risk, as shareholders in Citigroup in 2008 can well attest.

Complaints about the money made by the owners of private hedge funds are without basis. Those firms were founded by entrepreneurs; no investor was coerced into investing with them. The formula on which their compensation is based is known to all. On the other hand, the employee of a public owned firm is dependent upon financing from public shareholders. It is the rare lack of failure of publically-held banks that permits Wall Street to persist in acting as the prodigal son – and when failure occurs, it is capital, not labor, that suffers the most grievously; as we have learned over the past two years, with stock prices’ still dramatically below their pre-crisis levels and Wall Street bonuses at record levels. The system of banks too big to fail owes its charmed life to the establishment that exists between them – the large banks – and Capital Hill. Capitalism should permit those enterprises that have run aground to fail, not be bailed out.

But it makes better headlines to go after “evil” and “greedy” hedge fund managers. That they are based in places like New York and Greenwich, Connecticut only enhances their appeal to politicians looking for a score. For a government rooted in populism, arresting and prosecuting hedge fund managers serves to distract voters from what President Obama deemed a “shellacking” at the polls three weeks ago and from the far more important problem of “too big to fail”. Whether it is the Attorney General for the Southern District of New York, the New York Attorney General or the SEC, their history of arrests being nullified and convictions being overturned is such that caution should be their byword. In acting rashly, the wrong people are made to suffer and the most significant consequence is that the fox that has been put in charge of the hen house who goes on to higher elected office.

Wednesday, November 24, 2010

As the turkey takes his final strut around the barnyard, there are many things for which we can be thankful, but a stable dollar is not one of them. Since the creation of the Federal Reserve in 1913, inflation has depreciated the dollar at a rate of 3.3% - meaning that the dollar has lost a little more than 95% of its value over those 94 years. In contrast, during the 113 years preceding the formation of the Federal Reserve, inflation compounded at a far more moderate 0.5%. Warren Buffet has taught us the value of compounding returns on investment. The inverse – the effect of inflation on the dollar – is insidiously destructive for the same reason.

We should be thankful that we live at a time and in a place where criticism of government is part of our fabric. We enjoy freedoms that most people on earth cannot imagine. We have the ability to go where we choose, to assemble and speak and write as we will. In a democracy as old as ours, these freedoms are often taken for granted. They should not be. Personally, I am blessed with a loving wife for almost forty-seven years, three wonderful children and their spouses and ten adorable grandchildren. As the song asks: “Who could ask for anything more?”

Well, I for one could, in terms of dollar stability. The problem, though, has been rooted more in fiscal than in monetary policy. Following the signing and enactment of the Humphrey-Hawkins Full Employment Act of 1978, inflation accelerated. The purposes of that bill, which replaced the Employment Act of 1946, were four-fold: “full employment (no more than 3%), growth in production, price stability (not over 4%) and balance of trade and budget. Thirty years on, the results have been mixed, at best. Unemployment, in the past decade averaged 5% and is now at 9.7%. GDP, according to data compiled by Chris Chantrill (my daughter-in-law Beatriz’s father), has grown from $2.294 trillion to $14.258 trillion, a compounded rate of 5.6%. Inflation has compounded at 3.9%, indicating that the dollar has lost a third of its value. For most, if not all, of the past thirty years we have been a debtor nation in terms of trade, and, other than three years in the late 1990s, the budget has been in persistent and rising deficit; it is now $1.4 trillion in arrears. Should members of Congress have been employed in the private sector they would all have been fired. One would think they would be held to higher standards.

As a nation of consumers who must become a nation of investors and savers if we are going to compete in the global arena, a depreciating dollar does little to promote the cause. It is not a lower dollar that will be our salvation. What is needed is a better educated more creative and industrious citizenry who are properly incentivized with a tax system that encourages investment and risk-taking. The yield on the Ten-Year is 2.8%; yet, as noted above, inflation has compounded at 3.2% over the past century. Perhaps, Congress, the President and the Federal Reserve now have religion, but that is not a good bet, in my opinion. Negative returns do not induce individuals to save.

Technology and productivity improvements have brought down the costs of many new consumer products, but healthcare and education have seen costs rise exponentially and companies in those sectors have seen their relative market values diminish. Despite arguing their cause, government policy has created an environment unfriendly to capital flows into these vital industries. Steve Galbraith of Maverick in a recent piece entitled “The Visible Hand”, notes: “Biotech companies now trade at steep discounts to DVD delivery companies, HMOs are valued at multiples two-thirds those of fast food chains…education companies are held in lower esteem than Playboy Enterprises.”

An October 20, 2009 Wall Street Journal article pointed out that Congressional budgeters in 1965 said that Medicare would cost $12 billion in 1990. Its actual cost was $90 billion. Richard Lariviere, President of the University of Oregon wrote in yesterday’s Wall Street Journal that “tuition has increased 7.5% each year for the past 38 years.” That means that tuition today, at the Eugene, Oregon university costs 15.6 times more than it did in 1972 – more than double the rate of inflation!

So, at this time of Thanksgiving, I do find myself thankful, but also fearful that the degradation of the dollar may eventually prove Voltaire correct when he wrote more than two and a half centuries ago: “Paper money eventually returns to its intrinsic value – zero.”

On that note, I leave for Connecticut with the thought we should be thankful for those people for whom and to whom we are responsible, for the gift of freedom given to us by those who came before, and I wish the Lord grant wisdom to those who run our government and control our money supply.

Tuesday, November 23, 2010

The increasingly intense debate as to whether our personal freedoms are being violated by overly zealous TSA (Transportation Security Administration) employees groping our most private areas, or whether our health – not to mention our self-respect – is endangered through exposure to X-Ray machines that can look beneath the clothes we wear is a reminder of the distance we have travelled since that horrific day more than nine years ago.

It is understandable why so many see their rights violated – a government that can put its hands between one’s legs or peer under one’s skirt is a government capable of lifting one’s wallet or tracking one’s travels. At LaGuardia last week I was prodded, poked and patted down. I was made to stand before a shield with hands overhead, while anxious heads pondered the wonder they beheld beneath my clothes. And, for almost fifty years, I have had my wallet picked every April. I cannot say that I would choose this option but, then, neither do I like my periodic visits to the proctologist. But I understand their purpose and I can live with them.

The principal role of government is to protect its citizens. Expectations, in the immediate aftermath of 9/11, were that Islamic terrorists would strike again. We know that they have tried and have failed, usually due to their own incompetence; at other times authorities, exercising their competence, arrested the perpetrators before the event. Each year almost 800 million people fly domestically and internationally from airports within the United States and from foreign airfields to the U.S. That means that about seven billion people have flown within, to or from the U.S. over the past nine years – that not one plane has been hijacked during that time is a tribute to those charged with keeping us safe. That includes the employees of the TSA.

A visit to my eldest granddaughter’s school this morning – grandparent’s day at Sacred Heart in Greenwich – served as a reminder of the preciousness of life – lives for which these Islamic terrorists are intent on destroying. An extra few minutes in a security line seems a small price to pay.

Is there more that could be done to make flying easier and more customer friendly? I am sure there is. Technology today is such that every boarding pass could have embedded in it a chip providing data about the passenger – nationality, age, gender, prior countries visited, how was the ticket purchased, is the ticket a round trip- enough information to provide the TSA a profile of the passenger, so that they could more closely focus on those that fit certain characteristics, rather that randomly selecting an elderly woman or a young child.

But, in the meantime, if I must forego certain rights that make flying safer I am willing to do so. I recognize that clever people intent on killing can do so. Chance plays a powerful role. I would prefer not to be frisked and I hope that technology permits intelligent profiling; so that those who travel frequently and have shown themselves not to be a security threat will be permitted the free pass recently granted John Boehner, the soon-to-be Speaker of the House. Is the hassle demeaning? Perhaps. Is it inconvenient? Yes, but understandable.

As for taxes and my proctologist, I don’t like them either. The latter is simply a necessity as one ages and the former is the price we pay for living in this land.

There are issues that are far more critical; one’s that should consume more of our focus – education, immigration, tax policy. The time and the energy being expended to prevent some employee of the TSA from putting his hands between my legs could be better spent on more pressing issues.

Monday, November 22, 2010

Rahm Emanuel once infamously stated that a crisis is a terrible thing to waste, but it is also true that, purely serendipitously, good things can came from crises. The recent economic and fiscal turmoil have produced at least two positive developments. One is the preliminary report on tax strategy – overhauling the current tax code by proposing simplified rates for both individuals and corporations that largely do away with standard deductions – from the deficit commission appointed by President Obama. The second is the agreement by unions to accept tiered contracts, described in a front page article in Saturday’s New York Times. The tax strategy plans, at their core, are pro-growth initiatives and are surely the most effective and least painful way of reducing the federal deficit. The second is an acknowledgement that we are part of a global economy and that high labor costs deny us the ability to compete effectively with the East.

It is true that neither proposal is assured of acceptance or continuance, but at least the weather vane is pointing in the right direction. Congress may decide to neuter the deficit commission, or the President may choose to ignore its findings. Labor, once the recession is over, may well resort to their traditional single tier contracts.

The only thing binding about the recommendations that are due from the deficit commission in early December is that if fourteen of the eighteen members approve the statement, Congress must consider their recommendations. However, President Obama has the opportunity to restore economic growth as the best means of tackling the deficit using the cover of the preliminary report issued by Erskine Bowles and Alan Simpson. The President can also cite another blue ribbon commission which came to a similar conclusion regarding the tax system – a group headed by former Republican Senate Budget Committee Chairman, Pete Domenici and Democrat Alice Rivlin who was the founding director of the Congressional Budget Office and director of the Office of Management and Budget for President Clinton. Simplifying and lowering tax rates would benefit everybody except lawyers and those who represent special interests. (Parenthetically, let me add that we all have special interests, but those should be subordinated for what is best for the country.) As N. Gregory Mankiw wrote in Sunday’s New York Times, “I am willing to give up my favorite tax expenditure if everyone else is willing to give up theirs.”

There is little question that the President may lose the far left should he adopt the co-chairmen’s recommendation, but he would gain the approval of the far larger group of independent voters and almost assure his reelection prospects in 2012.

The concept of two-tiered labor agreements is not new to the current recession. They were used, as the New York Times, pointed out, in the early 1980s. However, with recession over, subsequent contracts in the past reverted back to single tiers. Today, though, global competition is far more intense. The United States remains the foremost manufacturer in the world, but China is on the brink of surpassing us. In the past ten years China has, according to Niall Ferguson writing in the weekend edition of the Wall Street Journal, already overtaken Germany and Japan in the past ten years. “The world”, as Professor Ferguson writes in his article entitled In China’s Orbit, “is tilting back to the East.” On a recent visit with two of our analysts to Harley Davidson’s headquarters in Milwaukee – a company highlighted in the Times article – management seemed adamant that a return to prior labor contracts was not in the interests of union members, shareholders or management. The auto industry, brought to its knees by unrealistic union demands, was saved only because of government interference. A government industrial policy is a route fraught with expense, inequality and inefficiency and doomed ultimately to fail. A business that is able to compete is one that is able to grow, thereby providing job opportunities. It does not necessarily mean a return to Boulwarism, but it suggests that expectations by labor will have to be scaled back to allow the businesses they choose to organize to prosper. In biology, a parasite that destroys its host is doomed to die. Today, many failing state and local governments are vivid examples of this hedonistic, delusional attitude. “What we are doing,” Harley president and chief operating officer Matthew S. Levatich is quoted as saying in the Times article, “is not mean-spirited. We have to retool if we want to survive.”

Perhaps I am too Panglossian, but indications of positive change provide hope. We certainly continue to face thorny problems: unsustainable deficits; far too high unemployment; an education system that lags much of the world, and immigration reform. A growing sense of dependency on government, embodied in the healthcare reform bill, is an impediment not an aid to being competitive in today’s globally competitive environment. As an aside, the NHS (the National Healthcare Service) in England, a country one fifth the size of ours in terms of population, is the world’s fourth largest employer, following the Chinese army, Wal-Mart and the Indian National Railway. One can only imagine the bloated bureaucracy that faces us over the next couple of decades, should the healthcare act be implemented.

“What we are living through now”, Professor Ferguson concludes, “is the end of 500 years of Western predominance. This time the Eastern challenge is for real.” One has to only look at the three largest cities in the world (according to World Statistics) – Shanghai, Mumbai and Karachi – to recognize the remarkable change that has been taking place. (In 1900, according to Mr. Ferguson, the three largest cities in the world were London, New York and Paris.) These shifting dynamics present opportunities, but only if we have the will and the wherewithal to compete. It is why the possibility of real tax reform and a more realistic attitude by labor present the possibility of roses among the thorns.

Friday, November 19, 2010

Two years ago the country was in a funk, to put it mildly. The banking system had come frightening close to melting down in September-October of 2008. While credit markets were beginning to recover, we were facing a very severe recession. On the other hand, a whiff of spring was in the early winter air with an unpopular president being replaced by one for whom people had very high expectations.

Over the years leading up to the end of the first decade of the 21st Century, General Motors had become a poster child for what ailed American competitiveness. The liabilities of the company had become bloated with promises to union workers that became impossible to keep – promises based on hope, not reality. Those demands caused costs to rise, resulting in shoddy manufacturing using cheaper, less reliable components; competition from abroad produced better, safer cars, forcing American companies to compete on price. CBS News calculated in a February 26, 2009 report that GM lost $3700 per vehicle produced in 2008.

During the two and a half decades following the end of World War II, General Motors came to symbolize America’s growing industrial strength and its reputation for quality. In 1953, Charles Wilson, President of GM, was nominated to be President Eisenhower’s Secretary of Defense. In response to a question about conflicts of interest, Mr. Wilson replied: “For years I have thought that was good for our country was good for General Motors.” For years Mr. Wilson was misquoted, as saying what was good for GM would be for the country. That seems to have been the interpretation that President Obama took yesterday in praising the offering and suggesting that tax payers were well on their way of getting their $50 billion investment returned.

In a sense GM had made a pact with the devil, as they had subordinated the interests of shareholders to the demands of union workers. The end game was inevitable. The shutting of the markets for the issuance of commercial paper in late 2008 forced the issue. GM, without a government bailout, would be forced into bankruptcy. The Bush administration, in late December, advanced the company $13.4 billion. The terms of the loan, according to a Wall Street Journal report at the time, required the company “to extract enough concessions from workers, suppliers, dealers and other stakeholders to demonstrate their long-term viability by the end of March.” In doing so, the administration turned the tough decisions over to the incoming Obama administration. Shareholders had already been punished. On November 24th 2008, General Motors closed at $2.92, “Its lowest close since April 1943”, according to CNNMoney.com. Merrill Lynch had a “sell” on the stock with a price target of $0.01.

Within a month of his inauguration, President Obama injected another $36 billion – pushing the total investment to $50 billion. In March, the administration backed new car guarantees and forced the firing of CEO Rick Waggoner. But that still was not enough to save the company. So on June 2, 2009 GM became the second largest industrial bankruptcy in history, a bankruptcy orchestrated by the government. At the time of the filing, GM had $172 billion in liabilities and $82 billion in assets. A government induced bankruptcy permitted the court to place the bond holders beneath the unions and, according to today’s Wall Street Journal, allows the company to exercise a tax-loss carry forward on $45 billion, a provision not typically permitted. As the Journal puts it: “Translation: Taxpayers will continue to aid GM for years.” Forty days later, on July 10, the company emerged from bankruptcy, far more quickly than most had expected. Bankruptcy allowed the company to slash its debt and healthcare obligations by $48 billion, drop almost 40% of their dealers and shed unwanted brands. Old, unwanted assets, including shuttered plants, became Motors Liquidation Co., which is expected to remain in bankruptcy for some time.

Emerging from bankruptcy, stock ownership was as follows: the U.S. Treasury, 60.8%; the UAW, 17.5%; the Canadian government, 11.7% and the bond holders, 10%. At $33, the equity value of the new company is about $50 billion. The bond holders had been owed $27 billion. Based on the offering their stake is now worth about $5 billion. In contrast, the UAW’s health plan, owed about $20 billion, is now worth approximately $8.5 billion.

Yesterday’s IPO amounted to 478 million shares. An additional 71.7 million shares are expected to be offered as the underwriters exercise the green shoe. Ninety-four percent of the offering traded yesterday, suggesting a number of those offered stock on the deal decided a quick profit was worth more than the risk of holding on. Of course, for every share sold there was a buyer. The unknown question is how much of the buying was done by the underwriting syndicate. The next few days will tell that tale.

The government needs the stock to trade above $53 (60% above the close) to break even on its $50 billion investment, and that doesn’t include ongoing taxpayer support. Nevertheless, we are better off for the public offering.

The bigger question is the one that asks: was what was done for GM will be good for America? Time will answer that question. There is little question that jobs have been saved, but at what price? The company has been given the opportunity for renewed life; debt and obligations have been eliminated; dealers have been closed and unsellable assets discarded. Some of the old problems like unrealistic union demands, though, have been back-burnered, not eliminated. Government’s involvement persists. Promoting a “green” car, the Chevrolet Volt, priced at $40,000, is a priority of the administration. Given an average income in the U.S., the price is high, even with a $7500 tax credit – another indication that tax payers are still on the hook. Does this portend more government involvement in industrial policy? Will it be good for America? I’m skeptical, but at this point the jury is out.

Everyone has had unusual travel experiences. I almost wrote “trips from Hell”, but that would not be true about mine yesterday. This was just different.

On Tuesday I went to visit my brother Stuart who three years ago moved to the flat, but generally ice-free, plains of West Texas in Abilene. He had moved from the decidedly rocky – and often icy – hills of New Hampshire. Stuart suffers from a condition known as Prader-Willi Syndrome, which stunts growth, causes obesity and impacts motor skills. Nevertheless, he is an accomplished artist and has exhibited in Boston, New York and New Hampshire; however, ice, snow and Stuart do not mix well.

The trip out was uneventful. Not so the return.

My 10:40AM American Eagle flight from Abilene to Dallas was cancelled; thereby imperiling my 1:00PM connection to New York. Mechanical trouble was cited as the cause; so my plane limped from the gate to wherever they take ailing jets in Abilene. The next two flights were booked solid, but I was promised a seat on the 5:00PM. If you have ever been to Abilene you will know that the idea of spending six hours at their airport, as pleasant as the employees are, is not something you would wish upon your mother-in-law.

So I did the “New Yorky” thing. I booked myself on the 3:30PM from Dallas and called a car service.

That took a while, because car services in Abilene are rare. Nevertheless, the Classic Cab Company came through, but by the time they did I had to cancel the 3:30PM and re-book on the 4:25PM, this time upgrading myself to first class, as compensation for the pain and suffering I had already endured.

My driver, Bud Gonzales who is the owner, showed up about noon – in a white pickup truck for the 200 mile ride to Dallas-Fort Worth Airport. Of course, finding an abandoned, desperate east coast stranger he had no compunction in charging New York prices. Given my state, I hardly noticed. Throwing my bag in the bed of the pickup, Bud proceeded to talk his way to Dallas. I learned more than I needed about his early life in Del Rio and Sanderson and that the common term for 1000 acres is a “section”, as in “how many sections does your daddy’s ranch encompass?” We passed dozens of ranches, a couple of hills scattered here and there, and the carcasses of several mule deer who had made the mistake of venturing onto I-20.

Other than the fact there was no gun rack behind my back, the truck was indistinguishable from most of the other vehicles on the road. Feeling like a stranger in my country, I felt as Dorothy did when she said to Toto, “we’re not in Kansas anymore.”

Forgetting the size of the DFW airport and not having asked my travel agent for a gate number, I was deposited at terminal “C”, instead of “D”. However, the satisfaction of rolling up to the first class entrance in a white pickup made the fact that I was at the wrong terminal tolerable. Besides, the skytrain gave me an engineer’s view of the airport.

Naturally, the 4:25PM did not take off until 6:35PM – an hour and a half after I should have landed in New York.

Monday, November 15, 2010

A year brings big changes. In 2009, newly elected President Obama traveled three times to Scandinavia. The first was a plea before the International Olympic Committee meeting in Copenhagen that Chicago be the venue for the 2016 summer Olympics. His bid fell flat, and Rio de Janeiro was selected. Two months later he was in Oslo to accept the Nobel Peace Prize – not for any peace he had brought the world, but for what the committee hoped he might accomplish. Just over a week later, on the 18th of December, he was back in Copenhagen to “crack the whip”, as the Christian Science Monitor put it in a headline at the time, “on the need to get a new global warming deal here before the clock runs out this weekend.” The clock ran out and the participants went home empty handed.

A problem inherent with climate alarmists is their implicit assumption that without man’s interference the status quo would remain. It is akin to the story of the boy who cried “wolf”. “An Inconvenient Truth”, in my opinion, did more harm than good to the cause of global warming. Mr. Gore and friends accuse all those who disagree with them as “deniers”. Most of the dissidents are merely skeptical as to whether man or nature is the primary or critical cause. Additionally, they are concerned as to the cost and its impact on economic growth. Bjorn Lomborg, director of Copenhagen Consensus and author of Cool It: The Skeptical Environmentalist’s Guide to Global Warming, wrote last week in the Wall Street Journal: “This time a year ago, passionate climate activists told us we had just weeks left to save the planet.” Activists at last year’s summit in Copenhagen saw that convention as, “our last chance to avert global warming.”

Freeman Dyson of Princeton’s Institute for Advance Study, a noted skeptic on global warming, is profiled in the current (December) issue of Atlantic by a somewhat sanctimonious Kenneth Brower. In the body of the report he did write: “Dyson did not deny that the world was getting warmer. What he doubted was the models of the climatologists, and the grave consequences they predicted.” But in foreword to the article Mr. Brower wrote: “In the range of his genius, Freeman Dyson is heir to Einstein – a visionary who has reshaped thinking ion fields from math to astrophysics to medicine…And yet on the matter of global warming he is, as an outspoken skeptic, dead wrong: wrong on the facts, wrong on the science.”

Global warming, or climate change, attracts very strong opinions. What is absent is rational discourse. Most everybody agrees that man has impacted the environment; the question is one of degree. Also, most everyone acknowledges that the earth has warmed and cooled over the millenniums. Justin Gillis had a fascinating article in Sunday’s New York Times. He wrote: “With the waxing and waning of ice ages, driven by wobbles in the earth’s orbit, sea level has varied by hundred’s of feet, with shorelines moving many miles in either direction.”

There is a cost associated with cleaning up the environment and reducing carbons that alarmists tend to ignore. The policy choice is “incredibly expensive”, as Mr. Lomborg wrote. He adds, “…alternative energy technologies are far from ready to take over from fossil fuels.”

The Kyoto Protocol (developed under the United Nations Framework Convention on Climate Change – the UNFCCC), negotiated and adapted in 1997 and never ratified by the United States, expires in 2012. It set binding targets for industrialized nations to reduce their emissions of greenhouse gasses, but gives a free pass to developing nations. Despite the adamancy of its supporters and the specificity of its demands, compliance has been less than total. President Clinton refused to submit the Treaty to the Senate “until developing countries are subject to binding emission targets.” President Bush, in February 2002, announced a U.S. policy that relies on voluntary actions to reduce the ratio of emissions to economic output by 18% over a ten year period. According to the Pew Center on Global Climate Change, the growth in greenhouse gas emissions in the U.S. rose 16% between 1990 and 2004, with almost all of the increase coming in the first ten years – during a time of rapid economic growth.

After the hype of a year ago when one hundred heads of state showed up in Copenhagen and the excitement over newly elected President Obama’s appearance electrified much of the world, expectations for the meeting in Cancun (November 29-December 10, 2010) are far more subdued. Heads of state will be replaced by bureaucrats and there has been little buildup in the Press. That may well prove a blessing. There is little chance that the upcoming meeting will be the public relations fiasco of a year ago. The Ontario, Canada based Kingston Whig Standard a month ago quoted George Monbiot, “the world’s most famous global warming journalist.” According to the paper, Mr. Monbiot predicted in his column in the Guardian: “Climate change enlightenment was fun while it lasted. But now it is dead.”

The benefits of reducing carbons must be weighed against the costs of implementation and their impact on economic growth. As Mr. Lomborg suggests” “If green technology is not ready to take up the slack, then forcing carbon cuts through taxes will simply hurt growth and development – particularly painful to developing nations.”

Whether man is the principal cause of climate change or not, mankind must be ready to adapt to changing conditions. A focus on blame detracts from the more important consideration of the millions of people living in low-lying areas, where only modest increases in sea level could have devastating effects. It is in man’s self interest to keep his environment clean and developed nations have decidedly moved in that direction over the past several decades. It is in the interest of all people to protect the environment as best they can and to be aware of the conditions and the risks that surround them.

Emissaries meeting in Cancun, while trying to extend and improve the Kyoto Protocols may well be forced to tackle the mundane problem of economic cost and the need to adapt to the changing nature of the world. A lack of pre-meeting publicity may serve to make the Cancun meetings more of a success than the hype and expectations did a year ago in Copenhagen.

Friday, November 12, 2010

In thinking of the deficit it is important to admit, understand and accept certain facts. First, the level of current spending and the size of the deficit, as a percent of GDP, are unsustainable. Second, no matter how wasteful a program or how errant an earmark, someone gets hurt when that program is defunded or the earmark voided. One person’s waste is another’s “essential” program.

With that as a background and against the odds usually associated with Washington’s blue ribbon panels, the draft from the eighteen-member deficit commission was remarkably sane. Democracies function when people of opposing views tailor their opinions to conform to an outcome acceptable to the majority. The draft and the recommendations – supposedly due out on December 1st – are not meant to be the last word, but as a starting point for debate. Of course, Washington being Washington, the hurdles to accepting anything close to the draft may prove insurmountable.

For most of the past fifty years the United States has operated with a deficit, but generally it has been manageable, with federal expenditures running just over 20% per year and revenues just under 19% per year. Recessions curtail revenue; resumption of growth increases revenue. Recessions cause federal expenditures to increase. Creating an environment to encourage private sector economic growth is generally the most efficient means of getting the deficit under control – rising earnings generate more tax revenue. But what happened in 2008-2010 was outside the parameters of normal bounds. Revenues declined to less than 15% of GDP, while expenditures reached 25%. But the increase in expenditures was also due to the Obama administration aggressively taking advantage of the crisis to enlarge the reach of government.

The draft presented by Erskine Bowles and Alan Simpson, co-chairmen of the deficit commission, would achieve its goals through spending cuts of three dollars for every dollar gained through tax increases. As would be expected, partisans on both sides of the aisle, but especially the Left, attacked the proposal. In fact, when Speaker of the House Nancy Pelosi called the proposal “unconscionable” and “unacceptable”, the President felt the need to call her out and suggest everybody read the fifty page proposal before commenting. At the same time, any tax increase is an anathema to conservative Republicans.

Aspects of the draft that I find refreshing includes the concept of lowering and simplifying both individual and corporate tax rates, while limiting deductions. Raising the level on which payroll taxes would be levied should not prove overly onerous; on the other hand waiting sixty-five years before raising the retirement age to 69 seems absurd. In an attempt to curtail the role of government in the economy, the proposal suggests that spending and revenues should not exceed 21% of GDP. I would prefer that government’s share be smaller, but as a guideline the number is useful.

Whatever is ultimately decided should be a proposal that recognizes the importance of the private sector in growing the economy; it should acknowledge the aspirations of the young and less affluent; it should encourage investment and discourage consumption; it should recognize the importance of trade to our economy and a realistic appraisal of our role in a changing world.

The importance of the panel and its recommendations will become clearer once interest rates rise, as they inevitably will. It is hard to believe that, in terms of interest rates, we are living in a time of grace, but we are. The deficit in 2011 is projected to be 10% of GDP, between $1.4 and $1.5 trillion, with total debt around $14 trillion. Interest rates are at historically low levels with an average maturity around five years. Unless that debt is reduced, an increase in rates will make today’s environment seem easy by comparison.

So I commend the President on having established the commission and I commend the commission on its draft. In stark contrast to the Group of 20 meeting in Seoul, which reached no conclusion regarding the frightening prospect of currency wars other than establishing “early warning indicators”, the deficit commission presented some real choices. However, the draft is just that, a draft. But it is a good starting point for debate.

Businesses, responsible to fewer constituents than government, make tough decisions like this every day. However, the Obama administration suffers a want of people with private sector experience. A failure to make the decisions necessary will be indicative of letting special interests take precedence over the good of the country. Contrarily, a willingness to make tough decisions is a mark of a strong leader.

A reasonable outline has been provided Congress and the administration. The next few months will be telling.

Thursday, November 11, 2010

Ninety-two years ago, at the 11th hour on the 11th day of the 11th month, the guns along the “long, white road” went silent. Four years and three months after the start of perhaps the most devastating war the world has ever known, the total destruction that had occurred began to be realized. Sixty-five million men had been mobilized; eight and a half million were killed; twenty-one million wounded and seven and a half million were either missing in action or became prisoners of war – all young men in their prime.

November 11th was commonly known in the United States as Armistice Day until 1954 when President Eisenhower signed legislation changing the name to Veterans Day. But, in my opinion, Remembrance Day seems a more fitting designation.

What made this particular war so terrible was that the continent of Europe had been peaceful for more than four decades following the conclusion of the Franco-Prussian War in 1871. The turn of the century had brought prosperity to Europe. The automobile, electricity and telephones were all recent inventions, increasingly available. Relatively free trade worked to mutual advantage. Music and the arts flourished. But in the dark recesses of industrial areas, companies like Krupp were producing weapons. So that when the armies met in the summer of 1914 it became a clash between the 19th and 20th centuries, with horses being mowed down by machine guns and planes providing reconnaissance on soldiers being provisioned by mules.

In a far different time, but reflecting the mood of proud but naïve soldiers marching to war that summer, words which poet John Pickering wrote in 1567 are prophetic:

“It is good sport to see the strife

Of soldiers in a row.

How merrily they forward march

Their enemies to slay,

With hey, trim and tricksy too,

Their banners they display.”

The War began with the assassination of Archduke Ferdinand of Austria in Sarajevo on June 28, though it would be August 1st before Germany declared war on Russia and August 4th before England declared war on Germany. Ensuing battles were immense. They took months to complete and when they ended troops were usually near where they began – a few feet of mud gained at a cost of thousands of lives. That was especially true for both the Somme and Verdun, battles that lasted six and ten months respectively, ending roughly where they began. Combined, the two battles saw a million two hundred thousand young men die. By the War’s end – the Great War as it was then dubbed – the Balkans, as appears their eternal fate, had suffered more than most. Nine percent of Romania’s soldiers were killed. Serbia lost 16% of hers. The toll was enormous. Ninety percent of Austrian soldiers were casualties, killed, MIA or wounded: 76% of Russia’s, 73% of France’s, 65% of Germany’s and 36% of Great Britain’s. A generation of young men was gone.

Shortly before he died of pneumonia in France in January 1918 and after he had witnessed the horror of the Western Front, Colonel John McCrae wrote the moving and memorable poem, “Flanders Field”. Part of it goes:

“In Flanders Field the poppies blow

Between the crosses, row on row,

……………………………..

We are the dead. Short days ago

We lived, felt dawn, saw sunset glow,

Loved and were loved, and now we lie

In Flanders Field.”

Unlike the first decade of the last century, a time of peace, prosperity and complacency, the first ten years of the Twenty-first Century witnessed the murder of 3000 Americans by Islamic terrorists on 9/11 and has experienced a financial credit crisis that threatened the world’s banking system. We live in a stress-filled world. However, there will be long stretches of joy and satisfaction interrupted by moments of horror. Currently, a lack of complacency serves to keep us on edge, rendering a near-term repeat of that earlier period less likely.

The tragedy of the Great War, the “war to end all wars”, was that it was never really concluded. The armistice in November 1918 ended with the Treaty of Versailles in the spring of 1919. The terms of that treaty were so onerous, however, that a consequence was that it laid the foundation for World War II; thus in many respects the war that began with the “guns of August” in 1914 did not finally conclude until the surrender of the Japanese aboard the USS Missouri in Tokyo harbor, in September 1945.

On this day of remembrance it is worth recalling not only the loss of those who died so young, so selflessly and so brutally, but of the vulnerability of the many to the culpability of the few. Smart people do not always make wise decisions.

Wednesday, November 10, 2010

Niels Jensen writing in his November 2010 “The Absolute Return Letter,” mentioned that earlier this year he had lunch with John Paulson, manager of his eponymous hedge fund. When asked about the next driver for investment returns, Paulson answered “currencies”.

Currencies, in the past few months, have become almost the exclusive focus of analysts, portfolio managers, stock brokers and the media. In the forty-three years I have been in this trade, there has always been something that momentarily assumes monumental importance. In the late 1970s, a rise in gold and silver prices attracted attention and resulted in the bankruptcy of the Hunt Brothers. In the early 1980s it was the money supply numbers that everyone waited for with baited breath on (I believe) Friday afternoon. Tech and internet stocks, where “eyeballs” were counted with exacting precision, sucked in investors and the media in late 1999, just before collapsing into a heap from which they still have not recovered. In June 2008 it was the price of oil, which rose to $140 a barrel, with Goldman Sachs infamously predicting a target of $200.

Today it is currencies and, specifically a supposed race to see which country can debauch their currency the most in the shortest period of time. The United States has done well in this race. Over the past ten years the Dollar, against the basket of currencies that comprise the Dollar Index, has declined 35%, implying a doubling of prices on imported goods every sixteen years. The Federal Reserve may be concerned about deflation, but a weak dollar and rising commodity prices mean that consumers’ income will be purchasing less.

The Group of 20 is meeting now in Seoul. Currencies will be the principal topic of conversation and will be made more interesting given China’s trade surplus for October reaching a new high of $27.1 billion. Less publicized, however, was the news that their imports were up 25.3%. China, in anticipation of the negative publicity their trade surplus would engender, raised bank reserve requirements by fifty basis points.

While concerns of the Dollar are legion, the truth is it is impossible to know what will happen. Jim O’Neill, newly named Chairman of Goldman Sachs Asset Management (and former Head of Global Economics, Commodities and Strategy Research for Goldman) has suggested that China and the United States have entered into a “grand bargain” for the Yuan. The decision to raise reserve requirements is indicative that such a possibility may be in the works. If Mr. O’Neill is correct, we may have to search for another concept on which to focus.

As investors we must always take care that in our daily pursuit of the “next new thing” we do not become myopic of long term opportunities.

Monday, November 8, 2010

The midterm elections have been scrutinized, parsed and debated ad nauseum. With the exception of Republican House leaders, no one seems truly satisfied. Independents, who swung the election in favor of Democrats in 2008, supported Republicans in 2010, not because they seemed to believe in their policies, but because they voted against Mr. Obama’s overreach and his failure to make headway against unemployment.

Despite his massive social engineering in proposing generational changes in healthcare and consumer protection against malpractices of lenders, the President claims he is not interested in an increasing role for government; he was simply responding to an economic emergency. Nancy Pelosi, despite engineering the loss of more seats for Democrats in the House since 1938, claims she has been asked to stay on as House minority leader, allegedly to ensure that healthcare and financial reform do not get neutered. “The bell that just rang isn’t the end of the fight; it’s the start of the next round.” So spoke Harry Reid, in a tone that suggests combat, not reconciliation.

Republicans seem equally uncertain as to whether it is Rand Paul (R-KY) or Roy Blunt (R-MO) that present the faces of today’s and tomorrow’s leaders in the Senate. (Read the piece in the weekend edition of the Wall Street Journal by Matthew Kaminski.) Mr. Kaminski writes of Mr. Paul who won by 12 points: “…he represents the new zeitgeist of the American right. Don’t count on him to sit quietly in the back benches.” Mr. Blunt, a former Congressman and Whip under Majority leader Tom Delay and who won his Senate seat by 14 points, was described: “…he epitomizes the transactional K Street politician who uses the prerogatives of office to protect incumbents – hence the nickname Mr. Earmark.”

From my perspective, the most important thing to get right in politics is economic policy. While there are times when it is imperative for government to interfere as they had to in the fall of 2008, in general the private sector is far better than the public sector in allocating capital. It is this belief that keeps me, and I suspect others, in the Republican Party. I also believe in a strong currency and free trade – tenants that are usually, though not always, associated with the Republican Party. In addition, Paul Ryan (R-WI) who will become House Budget chairman on January 1st has promised to tackle entitlement programs, where reform is necessary if the deficit is to be tackled. We will see if the boldness of his ‘Roadmap for America’s Future’ gets reflected in his proposed legislation.

On the other hand, Republican’s policies toward immigration, abortion, gay marriage etc. make me uncomfortable. I prefer a policy that welcomes immigrants, offers citizenship to those who have graduated from our colleges and universities and recognizes the value that immigrants of all nationalities and backgrounds have contributed to our nation. Obviously, we need to weed out criminals and those who are here solely for welfare benefits, but in general a policy of openness is better than one that is closed. Building a wall sends the wrong message. Sending home 15 million illegal immigrants is impossible, so some accommodation must be found. Also, as “legals” those immigrants would begin paying taxes, including putting badly needed money into cash-constrained Social Security and Medicare. In terms of issues like gay marriage, religion, guns and abortion, I simply don’t understand why they should be political issues at all.

While I find myself often more in sympathy toward Democrat’s policies on social issues, they are off-putting in their arrogantly dismissive manner toward those with whom they disagree. In universities, especially, they give lip service to the concept that all voices should be heard, but then blackball or rudely disrupt those whose views do not conform to their own.

On economic matters, Democrats generally share a belief in the “wisdom” of the state and a belief in equality that stresses outcomes as opposed to opportunity. In their paternalistic desire to provide entitlements, they emphasize compassion at the expense of aspiration. In their manner and demeanor, they have become increasingly elitist.

Both Parties have supported policies that have widened income gaps between rich and poor, between CEOs and the average worker. A consequence of President Clinton’s adoption in 1993 of Section 163(m) of the Internal Revenue Code limiting the deductibility of corporate compensation to $1,000,000 led to the proliferation of option grants, products which greatly magnified returns to senior corporate officers. Banks that are “too big to fail” have been supported by Democrats as much as Republicans. Financial reform legislation looks to allow big banks to become even bigger. The “Volker Rule” appears to being watered down.

In their campaigns, both parties spend too much time on social issues, and not enough on the more substantive and critical fiscal and monetary differences.

Over the past twenty years leadership in Congress has switched between Democrats and Republicans. They are reminiscent of a flock of sheep directed by sheepdogs, the electorate. They get chased to the left and then to the right, going in circles rather than making progress. Even so, the two main Parties have redefined themselves over the years and will surely continue to morph. White Southern Democrats of fifty years ago have become Republicans, while wealthy Northeast Republicans have become Democrats.

Nevertheless, my growing sense is of alienation of the many toward the few in Washington, made worse through an absence of term limits. Who in Congress really reflects our beliefs? Do they really care? Has the country become too big, too diverse for only two parties? Are two parties optimum? Is there any such thing as “mainstream” thinking”? Cooperation and conciliation have always been part of the political process, yet partisanship and anger are on the rise. The Tea Party is one consequence; there will be others.

Friday, November 5, 2010

Today marks the one year anniversary of the Fort Hood shooting. That along with explosive devices found in packages bound for Temples in Chicago are reminders that the war against Islamic terrorism continues. Early in his administration, President Obama, in his desire to be perceived by the world as the anti-Bush, favored the term “Overseas Contingency Operations” to the more direct, but less politically correct, “Global War on Islamic Terror”, the term favored by President Bush. In his inaugural, Mr. Obama did say “our nation is at war against a far-reaching network of violence and hatred.” But he also added that our security depends on “…the tempering qualities of humility and restraint.” The immediate response by the administration to Major Hasan’s rampage on November 5, 2009 was to deny that he might have been motivated by radical Islam.

President Obama has tripled the number of troops in Afghanistan, the “good war” in his words, as that is where Al Qaeda trained prior to the attack on 9/11. Yet the three recent attacks – one that succeeded and two that failed, not because of an alert Homeland Security Department but because of human error by the perpetrators – emanated from Yemen. The recently discovered packaged explosives also came from Yemen. Does that then suggest that invading Yemen would amount to another “good war”? There is no such thing as a “good war”. Wars may be “extensions of diplomacy by other means”, as Clausewitz wrote, but they indicate a failure of human discourse. They may be necessary, but they are never “good”.

Unfortunately the world has a small number of radicalized people whose hatred for others negates rational discourse. In every culture, including Islam, there are those who fit such a description. Leaders of groups such as Al Qaeda, Hamas and Hezbollah see nothing immoral in killing innocent civilians in advance of their cause. Investigative Project on Terrorism (IPT) has identified other organizations such as Revolution Muslim and Islamic Thinkers Society that are moving from ideology to violent action. At this time, Islamic terrorists have sworn to destroy our way of life.

A year ago today, Major Nidal Malik Hasan walked into a medical building at Fort Hood, Texas carrying two weapons and 200 rounds of ammunition. He shot and killed thirteen soldiers and wounded thirty-two. On Christmas day, Umar Farouk Abdulmutallab who was trained in Yemen attempted, but failed, to ignite a bomb he was carrying in his underwear. He had boarded Northwest flight 253 in Nigeria and tried to blow up the plane on its approach into Detroit. And then, on May 1 of this year, a crude car bomb failed to detonate in Times Square. The would-be terrorist, Faisal Shahzad, panicked and fled the scene before taking the necessary steps to cause the bomb to explode. He was captured the next day trying to flee the country. Like his two predecessors, his ties were to Al Qaeda in Yemen. White House Press Secretary Robert Gibbs, echoing the sentiments of Attorney General Eric Holder, said of that incident at the time: “We want to celebrate the success, rightly so, of what law enforcement was able to do.” Steven Hayes, writing in the Weekly Standard, corrected that perception: “success in the war on terror is not apprehending terrorists after their attacks fail. Success is preventing them from attempting the attack in the first place.”

In his speech to a Joint Session of Congress on September 20, 2001, President Bush said “Americans should expect a lengthy campaign, unlike any other we have ever seen.” It would be a “multi-generational” war waged by terrorists who kill “not merely to end lives, but to disrupt and end a way of life.” Mr. Bush also made it very clear that we were not at war with Muslims. “The enemy of America is not our many Muslim friends; it is not our many Arab friends. Our enemy is a radical network of terrorists, and every government that supports them.” Responding to the call, Muslim countries like Pakistan and Saudi Arabia volunteered their help. The balance of Mr. Bush’s Presidency was largely consumed with the war. Iraq was invaded in 2003 and Saddam Hussein was overthrown. In 2006, the President deployed the Surge, which succeeded in wrestling victory for the fledgling government in Iraq from what seemed certain defeat. However, the war strained relations with allies, both Muslim and non-Muslim.

With Al Qaeda dispersed but still alive and U.S. soldiers’ deaths mounting, the President’s popularity plummeted. Not surprisingly, long wars have never been popular with Americans. Despite attempts, there were no further successful terrorist attacks on the U.S. mainland during the balance of Bush’s Presidency, a possibility that seemed remote in the immediate aftermath of 9/11. Regardless, with Bush’s poll numbers at record lows as he left the White House, newly elected President Obama felt compelled to speak to the Muslim world, which he did in Cairo on June 9, 2009. His purpose was “to seek a new beginning between the United States and Muslims around the world; one based upon mutual interest and mutual respect.” Nevertheless, not much has changed, in terms of relationships in the Middle East, in the subsequent seventeen months.

What makes this particular war so insidious is its uniqueness and unconventionality. Conventional warfare does not work. The enemy is not located in a single place. They are unseen, yet omnipresent. It is amorphous; it slips through defenses as mercury through one’s fingers. The enemy has patience; they can wait months or even years between attacks. They are not easily identifiable; their combatants wear no uniforms and can even hide under hijabs. They are merciless. They recruit people from every country, including the United States. They prey on the unsuspecting; civilians are their preferred targets.

We have been fortunate in that we have not been attacked since 9/11, but that does not mean we should let our defenses down. The passage of time has dimmed the fear we all felt on September 12, 2001 and that is a good thing, for we must go on with our lives. However, the innate decency, naïveté and generosity of Americans should not inhibit us from taking the offensive in ferreting out those who would do us harm.

Despite continued Islamic terrorists’ attempts, much of the West seems to have moved on toward what they perceive to be a post-war world rid of the elements that brought on 9/11. Gideon Rachman, a respected columnist with the Financial Times recently wrote a piece, “Obama may just be an interlude.” He questions the belief of conservatives in “American Exceptionalism”. Mr. Rachman liked the answer Mr. Obama provided Edward Luce of the Financial Times to a question about American exceptionalism in June 2009. When asked if he believes in it, Mr. Obama said he did, “just as I suspect that the Brits believe in British exceptionalism and the Greeks believe in Greek exceptionalism.” While I, too, believe in the truth of Mr. Obama’s clever response, Mr. Rachman’s fixation on Mr. Obama’s answer suggests myopia when it comes to the attitudes of conservatives. He doesn’t allow for the fluidity of attitudes, as people adapt to a fast-changing world. The United States remains the preeminent global superpower, but its significance shrinks as the East rises. That is obvious to all. However, America does remains unique in its composition of peoples from all nationalities, in its openness, in its geographic position, in its economy and political institutions. Does that it make it exceptional? Perhaps not, but it remains the favorite destination for those looking to emigrate for reasons of opportunity. Mr. Rachman should not fear a conservative becoming President. The country is bigger than any one man. His concerns, though, do suggest a belief he must have in exceptionalism, the exceptionalism of Mr. Obama.

The threat of Islamic terrorism persists. Americans must feel comfortable that their leaders in Washington will never relent in their pursuit of the enemy. President Bush was correct in identifying the enemy as Islamic terrorists and President Obama was correct in acknowledging the need to maintain relationships with the Muslim that are respectful, strong and trusting; for ultimately the eradication of Islamic terrorism will have to come from within the Muslim world.

Thursday, November 4, 2010

The election is over. The results (or rather, most of the results) are in and Republicans were clear winners, which was not a surprise. This was the largest shakeup in the House in sixty-two years. Nevertheless, as I wrote last Wednesday the vote was not so a much a vote for Republican policies as it was a repudiation of the President’s agenda, a fact his news conference suggests he fails to understand, or to admit.

From my perspective, the key takeaways are 1) the increasingly obvious split in the country, between the bi-coastal Democrats and the Southern and Mid Western Republicans, and 2) the fact that an increasing number of people split their votes, suggesting that contrary to the President’s comments most people do understand the issues and they voted deliberately. Even in a state as partisan as New York voters split their votes. For example, according to the New York Times, while Schumer and Cuomo both won more than 60% of the vote, the State Senate will be almost evenly split. In Kentucky, where Rand Paul won 55.8% of the vote, the State House will be predominantly Democratic.

If anything, the new Congress looks to be more partisan than the last. The Wall Street Journal reports that twenty-two of fifty-three members of the conservative Blue Dog Democrats lost on Tuesday and five are retiring, whereas only four of the eighty-two members of the liberal Congressional Progressive Caucus lost their seats. At the same time, the Republican Party may look more conservative, as several Tea Party candidates were successful. According to the Wall Street Journal, five Senate candidates supported by the Tea Party were winners – Ron Johnson in WI, Mike Lee in UT, Rand Paul in KY, Mark Rubio in FL and Pat Toomey in PA. In terms of the House, the New York Times suggests that thirty-two Tea Party candidates were elected.

Curiously, money appeared to play a contrarian role. On Tuesday, the New York Times reported that through last Friday Democrats outspent Republicans across all House races ($159 million to $120 million), despite the negative publicity surrounding right-leaning corporate spending. Their spending was more than offset by public unions’ spending on Democrats. In contrast to House races, in Senate races, where Democrats will keep control, Republicans outspent Democrats $159 million to $120 million.

While I continue to believe in term limits, those who disagree will take satisfaction in the concept that voters have the ability to impose term limits every two to six years. However, there are “safe” districts that both Parties enjoy, For example, in New Jersey, which has thirteen Congressional seats, only one incumbent lost – John Adler lost to Jon Runyan. In Harlem, ethically challenged Charles Rangel won his twenty-first race with 80% of the vote.

Republicans did better than expected with Hispanics. If Republicans are smart they will build on this foundation. They won two governorships, both by good percentages: Susana Martinez in New Mexico and Brian Sandoval in Nevada. Marco Rubio will be come Florida’s newest Senator. Mr. Rubio is a young, telegenic, articulate Cuban-American who could become a star in the Republican Party. Surprisingly, in a media-centric world, recent Republican national figures have not been great speakers. Mr. Rubio is.

Governing is more difficult than campaigning. It is easier to criticize legislation than to enact it. As a high school debater, I always preferred the con to the pro. The immediate concern of the lame duck session of Congress will be to deal with the Bush tax cuts scheduled to expire on January 1. The principal challenge for the new Congress will be to deal with the economy. The leaders of both Parties, and the President, must set aside differences and work together. Unemployment remains far too high. Given natural additions to the labor force (about one percent per year) and productivity gains (about two percent), the economy needs to grow at a three percent annual rate just to keep employment even. Republicans must not make the mistake Mr. Obama made when he put healthcare and cap-and-trade ahead of the economy. There may be parts of “ObamaCare” that Republicans would like to eliminate, but their first priority must be the economy. As Daniel Henninger titles his column today in the Wall Street Journal, the GOP must “unlock the economy”. If they don’t, 2012 will reverse 2010.

Wednesday, November 3, 2010

Generally accepted wisdom this morning suggests a Republican victory in the House and a pick up of six or more seats in the Senate will lead to gridlock. Perhaps it will. A combination of Presidential intransigence and Republican hubris are given as the reasons for stalemate. President Obama, in 2008, ran on a platform of post-partisanship, but as President he let ideology take center stage, creating division and resentment. Partisanship was the result; partisanship made more intense because of the economy. While we have two political parties providing the electorate a choice, most people’s preference is for programs that combine elements of both platforms. Regardless, when one party wins decisively, as the Democrats did in 2008, there is a tendency to accept victory as mandate. Hubris and arrogance, unfortunately, too often accompany victory, disallowing a move toward the center. In an infamous January 23rd 2009 meeting, newly elected Barack Obama told Virginia Republican Representative, Eric Cantor, “I won. So I think on that one, I trump you.”

This past election risks some of the same elements. While Democrats maintain control of the Senate, Republican pick-up in the House, with at least sixty seats, stands to be the largest midterm pick-up for either party since 1938, and the largest increase during a Presidential cycle since 1948. In the early hours, attempts at reconciliation were made, with President Obama calling Representative John Boehner just after midnight to congratulate him and with John Boehner exhorting his followers: “This is not a time to celebrate.” Jobs and the deficit pose major obstacles.

The Country is a complex place with hundreds of nationalities and millions of people with myriad opinions. It may in fact be a “center-right” country. I don’t know, but when one wins the Presidency with 52% of the vote, as Mr. Obama did in 2008, it was billed as a landslide; however, the President and the members of the dominant party should not have forgotten that 46% of the people voted for the other team. (Two percent voted for third parties.)

They should also consider Tony Blair’s admonition that it is easier to criticize than to govern, advice House Republicans must now keep in mind. They represent all the people, not just those from whom they received a vote. It is difficult to draw conclusions based on midterm elections. In 1940, two years after Republicans picked up 80 seats, Franklin Roosevelt won a third term. In 1984, two years after Democrats gained 27 seats, President Reagan won a second term. In 1996, two years after Republicans gained 54 House seats, Bill Clinton a won a second term. However, in years such as 1930, 1966 and 1974, House pick-ups were a precursor of a change in administration. The future, as the song goes, is not ours to see.

Gridlock describes a situation in which nothing gets done. Gridlock, or obstructionism, can be positive if the alternative is highly partisan legislation, but the route preferred by most people is one of reconciliation based on compromise. Partisanship is usually a consequence of one party’s domination, led by ideological leaders. Partisanship is divisive and can feed on itself, intensifying as the baton gets passed back and forth, creating an equal and opposing response, as leadership changes. You shove me; I’ll shove you. Of course, a feuding, paralyzed government would combine the worst attributes of both characteristics.

All may not be lost, however. Benedict Carey writing in yesterday’s Science Section of the New York Times sees some reason for optimism – that “subtle psychological factors will be pushing Democrats and Republicans in an unexpected direction – toward engagement instead of name-calling and nastiness.” Campaigns tend to highlight differences, as politicians generally speak to those of like-mind, and that’s what the cameras record – partisan politicians speaking to those sympathetic to their cause. Televised campaign speeches are staged events, showing ordinary people standing behind the speaker, smiling and nodding like puppets on a string. “The world’s a stage”, Shakespeare wrote; that is never more true than in televised campaign snippets.

In large part this election, at $2 billion the most expensive ever for a midterm, was a repudiation of the President’s policies. This President campaigned heavily in the last two or three weeks, making a dozen trips to Ohio. It did little good. The election was not a vindication of his policies. Tim Kaine, chairman of the Democratic National Committee and quoted in today’s New York Times gets it wrong: “Voters sent a message that change has not happened fast enough.” If that becomes the takeaway for the President and his leaders, then gridlock will be the result. On the other hand, if the President recognizes that ideology should take a back seat to pragmatic solutions embraced by the people and he shows a willingness to bend and listen, as President Clinton did in 1994, partisanship will wither and compromise will result. The people will be the beneficiary.

Benedict Carey goes on: “One reason sworn enemies may soften after the campaigning is over and they’re seated face to face is that conversation subconsciously synchronizes people physically – and to some extent mentally.” Let us hope he is correct.

Tuesday, November 2, 2010

While the election will be getting all the attention tonight and tomorrow morning, the meeting that will have the bigger and more immediate impact on our market will be the report from the Federal Reserves Open Market Committee, which meets today and tomorrow. The report, which will surely keep Fed Funds at 0.0 to 0.25%, is expected to recommend a second round of quantitative easing. General expectations place the total amount between half a trillion and one trillion dollars. Their decision will be rendered Wednesday afternoon at 2:15PM.

While stocks and commodities have rallied strongly since the Fed first hinted at the move back in August, bonds, the more direct beneficiary of quantitative easing, have fared less well. The S&P 500 is up 13.2% since the end of August. In contrast, the yield on the Thirty-Year has risen from 3.53% at the end of August to 3.96% today, indicating lower Treasury prices. LQD, the I-Shares for Investment Grade Corporates, is flat. On the other hand, HYG, the I-Shares for High Yield Corporates is up 3.6%. What the market is suggesting is that QE2 will aid speculation, which explains Wall Street’s endorsement. Cheap funding is positive for asset speculation, but it can lead to inflated asset prices, as any home owner who bought in 2005-2006 can well attest.

Arguing, as the Fed appears to be doing, that lower interest rates will stimulate the economy seems questionable to this observer. On the other hand, government assisted lower rates will continue what Jeremy Grantham refers to as the “pernicious practice” of engineering asset prices upward. That we have seen. Besides stock and junk bonds, since the end of August, silver prices are up 27%; lumber and wheat are up 29% and 63% respectively. Obviously, interest rates are not the only reason for the commodity price increases, but they sure have not inhibited the rise.

Fed funds have been at 0.0 to 0.25% since January 28, 2009, yet the economy feebly stumbles along. Despite five quarters of positive GDP growth, the economy is producing below where it was in the fourth quarter of 2007 and unemployment remains just under 10%. Thirty year mortgage rates are at forty year lows, yet housing starts are at the lowest level in fifty years. In 1975, with thirty-year mortgage rates at 9.05%, housing starts were in 1.032 million. Ten years later, in 1985, mortgage rates had moved up to 12.4% and housing starts were 1.71 million. Currently the thirty year mortgage rate is 4.35% and housing starts are expected to come in at 560 thousand units. The Financial Forecast Center is projecting an increase in the thirty-year mortgage rate to 4.86% by May 2011. Our housing analyst, Jeremy Pinchot, is projecting housing starts for 2011 of 750 to 850 thousand units. It does not appear that interest rates alone have much of an impact on housing starts. Jobs and confidence are the necessary (and missing) components.

There are those who argue that the government should increase spending when private industry does not. The notion is that this is the quickest way to get the economy moving. We have done that over the past two years with little effect thus far. But taking on more government debt when corporate cash is so high appears a misallocation of stimulus options. Corporations are generally in good financial shape. Reflecting improved corporate balance sheets, Investor’s Dealers Digest, S&P downgraded 94 corporate issuers and upgraded 124 in third-quarter 2010, bringing the global downgrade ratio, or downgrades as a proportion of total rating actions, to 43%. That ties with the second quarter of 2007 for the lowest downgrade ratio of the decade. Government should consider options that encourage corporate investment – a lower corporate tax rate, less cumbersome regulation and direct incentives for investment. There is no one who disagrees that the road to recovery lies with increasing economic growth; disagreements have to do with the best way to achieve it.

Paul Krugman, in Monday’s New York Times, writes of moralizers “mugging” his preferred way of exiting the debt quandary. He writes: “government should be promoting widespread debt relief; reducing obligations to levels the debtors can handle is the fastest way to eliminate the debt overhang.” “Moralizers”, he writes dismissively are “calling it a reward for the undeserving.” It may in fact be a moral issue, but far more important, it is an economic issue. For every loan there is a borrower and a lender. Much of the debt in this country is held either directly or indirectly by elderly, retired individuals. (If all the debt were held by the Chinese, the decision might be easier, but deciding to walk would still have consequences.) Artificially keeping rates low, as the Fed is doing, promotes asset speculation, produces inflation and impairs the income of the old and the thrifty. Making it easier to skip out on one’s obligations, as Mr. Krugman recommends, raises rates for future borrowers and makes credit less available.

I am not an economist, which I am sure is obvious to anyone who is, but I don’t understand the need for lower interest rates. I do, however, recognize the necessity of bringing back jobs and restoring confidence. I recently read a refreshing article by Virginia Postrel, entitled “In Praise of Irrational Exuberance”. She quoted John V.C. Nye who teaches at George Mason University: Mr. Nye argues that “countries become economically stagnant when their business people become too mature and rational.” A government which provides regulation and tax rules that promote confidence in the future will do far more for economic growth and jobs than by artificially pressuring interest rates lower.

Monday, November 1, 2010

According to the Financial Times, net trade knocked two percentage points off third quarter GDP. Exports of goods and services rose 5.0%, while imports increased 17.4%. The increase in imports came despite the Dollar Index declining 8.4%. There are only four components of GDP – consumption, business investment, government spending and the net of exports over imports. The consumer accounts for about 70% of GDP. In the current quarter, consumer spending grew at 2.6%, the most in four years. Nevertheless, he has been retrenching (increasing savings) and will likely continue to do so. Business inventories were up 5% in the quarter; however, without final sales increasing that is unsustainable. Federal government spending was up 8.8%, but state and local spending was down.

We are caught in this web: a consumer who needs to reduce his debt; small and midsize businesses with little confidence; a federal government that is growing exponentially, and a developing world that is increasingly better educated and more competitive than ours. The web is further complicated because of a banking system that is more capital constrained, in part because of Basel III requirements. Is this a “new normal” as the folks at PIMCO would have you believe, or a “new abnormal”, as the Wall Street Journal put it in an editorial on Saturday? I suspect PIMCO is closer to the mark, but who cares? It is the way the world is; we must deal with it.

While the federal government contemplates adding another half billion or perhaps a trillion dollars in quantitative easing, the consumer appears to instinctively understand Jeremy Grantham’s admonition: “there is no long term connection between debt and GDP growth.” Mr. Grantham presents a chart in his October quarterly letter that goes back to 1952. It indicates that over the past 28 years the debt to GDP ratio tripled, yet the rate of GDP growth slowed during those same years. Quantitative easing may help borrowers, but it hurts lenders. And, over the longer term, it will be inflationary; when that becomes apparent it will hurt borrowers, including the federal government (us, the tax payers!), for interest rates will rise. It is not lower rates that will jump start the economy; it is confidence. It is ironic (or perhaps not?) that unschooled consumers appear to have a better sense of what lies down this road of a bloated government adding new debt, than do highly educated policy wonks in Washington.

The most sensible way out of this mess is to focus on growth. A strong and expanding economy produces revenue for the government. A business-friendly environment is critical. Higher taxes impair growth. One can compare Texas to California, the nation’s two most populous states. One state is friendly toward consumers and business; the other is not. One has no income tax – Texas; California’s top rate is 10.55%. State and local spending as a percent of GDP is 18% in Texas, 25% in California. According to an October 22, 2010 report from the Bureau of Labor Statistics 22, unemployment in Texas is 8.1%; in California, it is 12.4%. And a focus on growth leads back to exports. A focus on exports is to understand the urgency of centering on education.

The Trends in International Mathematics and Science Study (TIMSS) is conducted every few years. One is being conducted this school year. The last was done in 2007. The study equates standardized test scores of eighth-grade students in each of the fifty states with their peers in forty-five countries. According to a New York Times study, while American children earned scores comparable to their peers in places like Slovakia and Estonia, they lagged behind children in Singapore, Taiwan, South Korea, Hong Kong and Japan. In fact the highest ranking states – Massachusetts in math and North Dakota in science – lagged those same Asian nations. In the lowest performing state – Mississippi – the scores were roughly equivalent to those in Bulgaria and Moldova.

Every President since Lyndon Johnson has made education a priority. Yet the state of public schools, especially those in poor urban and rural areas, has continued to decline. President Bush teamed up with Senator Ted Kennedy and presented the nation with “No Child Left Behind”. President Obama has his: “Race to the Top”. The main barrier to reform has been the teacher’s unions, which provide tenure after two years and, when budgets are cut, practice “last in, first out”. Meritocracy plays no role. The unions, because of their size, wield enormous weight. They are the single largest contributor to political campaigns with 90% of their money going to Democrats. To his credit, President Obama has been the first President to show signs of confronting the unions.

Like the passionately anti Communist Richard Nixon going to China in 1972, it will take a liberal Democrat to beat back the teachers unions. Perhaps Mr. Obama can do it. I hope so. I find myself at odds with many of his programs; but in this instance I believe he is trying to do the right thing. “Race to the Top” includes merit pay initiatives and looks to expand the number of charter schools.

But the problem runs deep. “Year after year, our schools are run for the benefit of the adults in the system, not for the benefit of the kids.” So wrote Michelle Rhee and Adrian Fenty in an article in Saturday’s Wall Street Journal. The American Federation of Teachers spent $1 million to defeat Adrian Fenty in the recent Democratic mayoral primary in Washington, D.C. (thereby effectively removing Michelle Rhee as chancellor of that city’s school system).

While our schools are mired in the past, the world is changing. The Group of Seven (G7 – Canada, France, Germany, Italy, Japan, the United Kingdom and the United States), as recently as 2000, comprised 65% of global GDP. Two weeks ago, Bloomberg, based on data compiled from the IMF, predicted that those seven nations will contribute less than 50% of global GDP by 2012. Our ability to maintain our standard of living will depend on our ability to compete in a smarter more competitive world. That starts with the school system.

One cannot watch Davis Guggenheim’s movie, “Waiting for Superman” without tears welling in one’s eyes, not just for the children living in homes that most of us cannot imagine and attending schools that in no way reflect the dollars spent, with they and their parents forced to sit through humiliating lotteries, but for our nation, which has allowed this condition to come to pass, and for what it means to our economic futures. We cannot halt the rise of the developing world. In fact we must embrace it, but we can halt the decline that is ours. Education and economic prosperity are inextricably linked.